Cap-and-trade could spur faster cleantech investment than carbon tax

I am painfully aware that the “cap-and-trade vs. carbon tax” debate, which was never particularly useful, has now become spectacularly pointless. Cap-and-trade is dead at the national level and seems to be slowly dying at the state level. And a carbon tax, despite the eternally brimming hopes of its many apostles, still has no chance in hell. So it’s a “unicorns vs. bigfoot” kind of thing at this point.

Nonetheless! For those of you still interested in the intellectual issues involved, I’ve just seen an interesting paper and want to dig up one aspect of the debate for re-litigation.

[Pauses while 97 percent of readers leave.]

OK. One of the benefits that people claim for a carbon tax is that it’s predictable. It is set at a particular level, or perhaps rises on a predetermined schedule, but either way industry will know what it is years in advance. This certainty, it is alleged, will give industry the confidence it needs to make long-term investments.

Cap-and-trade, on the other hand, can be volatile. The price of permits rises and falls according to market trends, economic growth, other commodity prices, and various other unpredictable factors. This uncertainty, it is alleged, will suppress industry investment.

In other words: predictability inspires confidence, confidence inspires investment. That’s one way that a carbon tax is allegedly superior to cap-and-trade.

I confess, this argument never made sense to me. It seems to me that volatility means risk, and if there’s one thing industry is quite accustomed to doing, its investing to hedge against risk — the more risk, the bigger the hedge. Why wouldn’t volatility in carbon permit prices prompt earlier and bigger investments? After all, what else in a competitive market economy is predictable? If businesses sat around waiting for “certainty,” they’d never invest at all.

But I’m no expert on this kind of thing, so I never wrote about it. However, bona fide experts have now come to my rescue. There’s a new paper in the The Energy Journal called “Inducing Clean Technology in the Electricity Sector: Tradable Permits or Carbon Tax Policies?” Authors Yihsu Chen (UC-Merced) and Chung-Li Tseng (U. of New South Wales) focus specifically on the question of how the two instruments would affect the timing of business investment. As they note, earlier is better: “From the perspective of technology diffusion, a desirable climate change policy should provide polluting industries with strong incentives to take early preventive actions.”

Chen and Tseng model the investment decision facing the owner of a coal plant under various scenarios. I won’t burden you with the technical details (there are many equations and graphs involved), but here are the two central conclusions:

First, C&T policies could effectively trigger adoption of clean technologies at a considerably lower level of carbon prices relative to a tax policy. Second, higher levels of volatility in the permit prices are likely to induce suppliers to take early actions to hedge against carbon risks.

So, you can get earlier investments with a lower carbon price with C&T. That’s pretty startling stuff!

It has huge implications for policy design too. As the authors note, real-world cap-and-trade systems like the EU’s and the Waxman-Markey bill tend to make heavy use of offsets and price control mechanisms (offramps, price ceilings, etc.), on the grounds that they will make carbon prices more stable and predictable. But if Chen and Tseng are right, that’s a bad thing; it will delay cleantech investments. It would be better, they say, to preserve the volatility and just give lump-sum rebates to industries you’re trying to protect.

Anyway, like I said, this is largely an academic debate, since in the real world Republicans are insane, Democrats are craven, and the Senate is broken. But in the unlikely event this policy question should ever be relevant again, this will be a nice study to have in your back pocket.